Even an Act of Congress Cant Stop the Fight Over Artificial Impairment

Even an Act of Congress Cant Stop the Fight Over Artificial Impairment

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Single-asset chapter 11 bankruptcy cases continue to be controversial topics in bankruptcy courts and scholarly publications. Such cases usually involve an income-producing parcel of real property (such as an apartment complex or an office building), a single secured creditor at odds with the debtor, some smaller trade creditors, and possibly some unpaid real property taxes. Most often, in single-asset cases, the value of the real property collateral is dwarfed by the amount of the secured debt, leaving the debtor and the secured creditor to engage in fights over classification of claims and absolute priority issues. Proponents of single-asset cases argue that such cases preserve value for general creditors that a liquidation could not, while detractors contend that single-asset debtors are not appropriate candidates for chapter 11 because they attempt to keep over-encumbered property without sufficiently maintaining it or paying secured creditors in full, while at the same time avoiding the adverse tax consequences that would otherwise result from a transfer of property.1

Even in the rare single-asset case where there is sufficient value in the collateral to pay the creditors 100 percent of their claims over time, the debtor still must jump the hurdle provided by §1129(a)(10), which requires an impaired class of non-insider creditors to accept the plan in order for it to be confirmed. In the rare cases where the single-asset real estate involved is worth more than the debt, the debtor and secured creditor still battle over whether a class that is "artificially" impaired can serve as an accepting impaired class for purposes of getting to cramdown.2

In certain respects, Congress responded to complaints of abuse in single-asset chapter 11 cases with the Bankruptcy Reform Act of 1994,3 which specifically addresses creditors' interests in single-asset cases.4 While the 1994 amendments do not directly address the issue of artificial impairment, they should (and do) alter the debate over the ongoing validity of artificial impairment as a concept. Before exploring the impact of the 1994 amendments, it is essential to understand the "traditional" debate over artificial impairment (which can be found in cases reported both before and after the 1994 amendments became effective).

In the November 1995 "On the Edge" column in the ABI Journal, we noted that per se application of the doctrine of artificial impairment presents a nearly insurmountable threshold barrier to a solvent single-asset debtor's ability to propose a cramdown plan of reorganization and, consequently, that it was time for courts to "call it quits" on artificial impairment as a concept. In the 1995 article, we updated a previous "On the Edge" article from 1993 in which we had documented the then-current split of authority over whether an accepting class of creditors can be impaired artificially under §1129(a)(10) in order for a single-asset creditor to achieve cramdown of a chapter 11 plan.5

The leading case for proponents of the concept of artificial impairment was In re Windsor on the River Associates Ltd., in which the Eighth Circuit specifically adopted the doctrine of artificial impairment.6 The Windsor rationale requires an "economic" justification for impairment, although no such requirement is specifically provided for in §1124.7 By contrast, in In re Hotel Associates of Tucson, the Bankruptcy Appellate Panel (BAP) for the Ninth Circuit directly rejected Windsor when it held that, under §1129(a)(10), an accepting class of unsecured trade claims that was paid in full 30 days after the plan's effective date constituted an accepting impaired class. As reported in the previous articles, because the Hotel Associates plan altered the trade creditors' rights, albeit not significantly, the Ninth Circuit BAP held that the class of unsecured trade creditors was impaired for cramdown purposes.8 However, the Ninth Circuit BAP incorporated a good faith requirement into §1129(a)(10), and remanded the case to the bankruptcy court with a directive that impairment for the purpose of gerrymandering a voting class of creditors is indicative of bad faith.9

Altering the Artificial Impairment Landscape

Although the wording of §1129(a)(10) itself was unaltered by the 1994 Bankruptcy Reform Act, a change to §1124 of the Bankruptcy Code provided a new twist on the concept of artificial impairment. Prior to the 1994 amendments, §1124 allowed for a class of claims to be unimpaired under a plan which provided a full cash payment of the claim on the effective date. Specifically, §1124 formerly provided that a class of claims is not impaired if:

(3)...on the effective date of the plan, the holder of such claim or interest receives, on account of such claim or interest, cash equal to—(A) with respect to a claim, the allowed amount of such claim...10

The 1994 amendments deleted all of subsection (3) from §1124, effectively removing a "cash out" option for debtors who wanted to unimpair certain creditors. The legislative history of §1124 reveals that subsection (3) was deleted in response to In re New Valley Corp.,11 in which unsecured creditors were denied the right to receive post-petition interest on their allowed claims despite the fact that the debtor was solvent. The New Valley decision had applied §1124(3) literally by holding that a class that is paid the allowed amount of its pre-petition claims in cash on the effective date of a plan is unimpaired under §1124(3). To add insult to injury, New Valley held that the foregoing class could not vote for or against the plan and was not entitled to receive post-petition interest.12

In order to combat this inequitable result, which would have the effect of providing a windfall to the debtor while disenfranchising certain creditors and robbing them of a voice in plan confirmation, §1124 of the Bankruptcy Code was changed to its current form. Consequently, if a plan were to propose "to pay a class of claims in cash in the full allowed amount of the claims, the class would be impaired, entitling creditors to vote for or against the plan of reorganization."13 Based on a plain reading of the resulting changes to §1124, it would appear that there would be no way that a class of claimants could be artificially impaired because even full cash payment to the class would constitute honest-to-goodness impairment under the Code.

If Congress had chosen to do so, it unequivocally could have ended the debate over artificial impairment by directly addressing the subject in the 1994 amendments. Because Congress did not address artificial impairment directly, it is reasonable to presume that the impact of the 1994 amendments on artificial impairment was inadvertent. However, the legislative history demonstrates that it was

Congress' specific intent to deem impaired a creditor receiving payment in full on the effective date.

Courts Still Disagree

In the post-1994 amendments era, certain courts have continued to employ the conventional analysis of artificial impairment to eligible cases without examining the impact of the change in the Code. The foregoing jurisdictions continue to be divided as to the validity of the concept of artificial impairment,14 which demonstrates the continuing lack of consensus that likely will ensue if the courts ignore the 1994 amendments.

Another line of cases, led by the Bankruptcy Court for the Northern District of Georgia in In re Atlanta-Stewart Partners, has seized upon the ramifications of the 1994 amendments, and has ruled that under §1124, as amended, "a class of creditors which will receive payment in full upon the effective date of the plan is impaired within the meaning of the Bankruptcy Code."15 Atlanta-Stewart involved an objection to the debtor's chapter 11 disclosure statement that allegedly artificially impaired a class of small, unsecured claims (classified as an "administrative convenience" class consisting of unsecured creditors with individual allowed claims of less than $1,000) by paying the class 95 percent of their claims.

The Atlanta-Stewart court took note of the legislative history of the 1994 amendments, and held that, even if the debtor's plan had paid the class of unsecured creditors 100 percent of their allowed claims, the 1994 amendments rendered even a fully paid class of creditors impaired because Congress purposely removed any language from §1124 that would have indicated otherwise. The court rejected the opponents' argument that §1124(1) mandated artificial impairment, stating that:

[T]he common sense reading of this subsection would not include payment in full. Obviously, a creditor who receives payment of its claim in its entirety does not retain any legal, equitable or contractual rights. In addition, the suggested reading of §1124(1) would have rendered the former §1124(3) superfluous.16

The Atlanta-Stewart court conceded that, at first blush, it appears contrary to traditional notions of impairment to treat a class of creditors receiving full payment as impaired. Yet, the court observed that such treatment provides advantages such as the avoidance of litigation over artificial impairment, and the resulting focus in confirmation battles on the more important topics of whether the plan is "fair and equitable" and in the "best interest of creditors."17 As of the writing of this column, four reported cases and one unreported case have cited to Atlanta- Stewart, and each of these cases either followed or at least recognized the validity of the holding in Atlanta-Stewart.18 By contrast, no court has attempted to repudiate the soundness of the Atlanta-Stewart decision.


The passing of the 1994 amendments ultimately should have eliminated the debate over artificial impairment and, therefore, removed the concept as an obstacle to plan confirmation. The current language of the Bankruptcy Code, along with the persuasive reasoning in Atlanta-Stewart and its progeny, should present a convincing argument that a claim need not and cannot be artificially impaired. However, it may take some time for all of the courts to recognize the significance of the 1994 amendments. In the meantime, courts that continue to deny the existence of artificial impairment without incorporating the 1994 amendments into their opinions are missing an opportunity to bolster their decisions with the support of the language and (indirect) legislative intent of the Bankruptcy Code. Likewise, courts that continue to employ artificial impairment analyses without taking the 1994 amendments into consideration are issuing opinions that ignore the Bankruptcy Code itself and, in the process, these courts are side-stepping the defining development in the artificial impairment debate. Until Congress takes further action or the Supreme Court specifically addresses the effect of the 1994 amendments, it appears that litigants in several jurisdictions will still be able to successfully argue the concept of artificial impairment, or, at least, its "good faith" implications, under §1129(a)(3).


1 For a recap of the status of single-asset real estate cases, see Joyce A. Kuhns, "Two Branches Ponder 'SARE' Role in Ch. 11," National Law Journal (September 28, 1998). Return to article

2 This is our third in a series of articles on artificial impairment. See Clemency & March, "'Artificial Impairment' and the Elusive Accepting Impaired Class in Single Asset Chapter 11 Bankruptcies," ABI Journal (Oct. 1993); Clemency & Harris, "The Fight Over 'Artificial' Impairment Under §1129(a)(10): It's Time to Call it Quits," ABI Journal (Nov. 1995). The foregoing articles provide more detail on the history and ramifications of §1129(a)(10) and the concept of "artificial" impairment, which generally involved paying a relatively small amount of unsecured claims in full shortly after the effective date of a plan. Return to article

3 The 1994 amendments are effective for all cases commenced after October 22, 1994. Return to article

4 See Kuhns, supra note 3, at B5 (and ensuing discussion on the 1994 amendments). Return to article

5 See Clemency & March, supra note 2. Return to article

6 7 F.3d 127 (8th Cir. 1993). Return to article

7 The language of §1124(1) provides that a class of claims is impaired under a plan unless the plan "leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest..." 11 U.S.C. §1124(1). Return to article

8 165 B.R. 470, 475 (9th Cir. BAP 1994). Return to article

9 Id. See, also, In re 203 North LaSalle Street Ltd. Partnership, 140 B.R. 567, 592-93 (Bankr. N.D. Ill. 1993) (recognizing that artificial impairment is better suited to the good faith provision of §1129(a)(3)), affirmed, 126 F.3d 955 (7th Cir. 1997), cert. granted, 118 S. Ct. 1674 (1998). Return to article

10 11 U.S.C. §1124 (1978). Return to article

11 168 B.R. 73 (Bankr. D.N.J. 1994). Return to article

12 140 Cong. Rec. H 10,768 (October 4, 1994). Return to article

13 Id. Return to article

14 See, e.g., In re Duval Manor Associates, 191 B.R. 622, 626-29 (Bankr. E.D. Pa. 1996) (providing a detailed analysis in rejecting the concept of artificial impairment and allowing intentional impairment of the "barest imaginable degree"); In re Dunes Hotel Associates, 188 B.R. 174 (Bankr. S.D.S.C. 1995) (following Windsor); In re 203 North LaSalle Street Ltd. Partnership, 190 B.R. 567, 592-93 (Bankr. N.D. Ill. 1995) (recognizing the split over Windsor, and observing that there is a "developing consensus among the decisions that the 'artificial impairment' objection is best seen, not as a ground for finding non-compliance with §1129(a) (10), but as an argument that a plan has not been proposed in good faith, a separate requirement for confirmation under §1129(a)(3)"), affirmed, 126 F.3d 955 (7th Cir. 1997), cert. granted, 118 S.Ct. 1674 (1998). Return to article

15 193 B.R. 79, 82 (Bankr. N.D. Ga. 1996). Return to article

16 Id. at 80-82. Return to article

17 Id. Return to article

18 See In re Crosscreek Apartments Ltd., 213 B.R. 521, 536 (Bankr. E.D. Tenn. 1997) (distinguishing decisions that forbade tactical impairment that were issued before the 1994 amendments, and agreeing with Atlanta-Stewart in concluding that, in light of the deletion to §1124(3), payment in full at confirmation cannot render a claim unimpaired); In re Park Forest Development Corp., 197 B.R. 388, 395 (Bankr. N.D. Ga. 1996) (finding Atlanta-Stewart reasoning persuasive, and refusing to deny confirmation merely because classes were intentionally impaired for cramdown purposes); In re The Seasons Apartments Ltd. Partnership, 215 B.R. 953 (Bankr. W.D. La. 1997) (following Atlanta-Stewart and ruling for unsecured creditors that fully paid claim was impaired because of the deprivation of post-petition interest); In re Equitable Development Corp., 196 B.R. 889 (Bankr. S.D. Ala. 1996) (recognizing that Atlanta-Stewart holding may be correct, but not applying holding to facts because administrative priority tax claims did not constitute voting class for cramdown purposes); In re Willow Creek Apartments Ltd., 1996 WL 343450, n.1 (Bankr. M.D.N.C. 1996) (citing Atlanta-Stewart in noting effect of 1994 amendments, but not applying the change to its analysis because the case was filed before October 22, 1994). Return to article

Journal Date: 
Sunday, November 1, 1998